CAPITAL BUDGETINGCAPITAL: capital here refers to long term assets used

in productionBUDGET: is a plan that details projected inflows and

outflows during some future period.Thus the capital budget is an outline of planned

investments in fixed assets.CAPITAL BUDGETING: is the whole process of

analyzing projects and deciding which ones to include in the capital budget.

STEPS IN CAPITAL BUDGETING PROCESS1. Estimate CFs (inflows & outflows). Ie. The cost of the project must be

determined as well as the estimated of the expected cash inflows from the project including the salvage value of the asset at the end of its expected life.

2. Assess riskiness of CFs. 3. Determine k = WACC (adj.). Given the riskiness of the of the projects,

management must determine the cost of capital at which the cash flows should be discounted.

4. Find NPV and/or IRR. The expected cash flows are then put on a present value basis to obtain an estimate of the assets value.

5. Accept if NPV > 0 and/or IRR > WACC. The present value of the expected cash inflows is compared with the required outlay. If the PV of the cash flows exceeds the cost, the projects should be accepted. Otherwise, it should be rejected. ( alternatively if the expected rate of return on the project exceeds its cost of capital, the project is accepted)

CAPITAL BUDGETING DECISION RULESFive key methods are used to rank projects and to decide

whether or not they should be accepted for inclusion in the capital budget:

1. payback method2. discounted payback 3. net present value (NPV)4. internal rate of return (IRR)5. Accounting rate of return (ARR)5. modified internal rate of return (MIRR)

PAYBACK PERIODThe payback period is the expected number of years required to

recover the original investment, or the length of time required for an investment’s net revenues to cover its cost.

DECISION RULE: based on the payback rule, an investment is acceptable if its calculated payback period is less than some prespecifed number of years.

EgHow many years will it take this projects to pay back?

.

Year (t) Project (S) GHC Project (L) GHC

0 (1000) (1000)

1 500 100

2 400 300

3 300 400

4 100 600

Sol.It will take 2.33 years for project S to pay back and 3.33 year for project

L to pay back. Hence if the firm requires a payback period of three year or less, project S should be accepted and project L be rejected.

MUTUALLY EXCLUSIVE PROJECTS: are a set of project where only one can be accepted. That is if one project is taken on, the other must be rejected.

INDEPENDENT PROJECTS: they are projects whose cash flows are not affected by the acceptance or non acceptance of other projects. That is they are projects whose cash flows are independent of one another.

From the example of projects S and L. if the projects were mutually exclusive ones, project S would be ranked over project L. because S has a shorter payback.

DRAWBACKS OF THE PAYBACK METHOD1. Ignore time value of money2. there is an arbitrarily cutoff. One of the biggest problem of

this method is coming up with the right cutoff period3. the method fails to consider any risk difference. The

payback is calculated the same way from both risky and very safe projects

4. ignore cash flows beyond the cutoffBiased against long term projects, such as research and

development and new projects ADVANTAGES

1. easy to understand2. adjust for uncertainty of later cash flowsBiased toward liquidtiy

DISCOUNTED PAYBACK

DISCOUNTED PAYBACK PERIOD: the length of time required for an investment’s discounted cash flows to equal its initial cost.

DECISION RULE: accept an investment if its discounted payback is less than some prespecified number of years.

Eg from the previous example of S and L, last assume cost of capital is 10%

PV = 500 + 400 + 300 + 100 (1.1) (1.1) (1.1) (1.1) = 454.55 + 330.58 + 225.39 + 68 = 2 + 214.87/225.39 = 2.95yrs for project SPV = 100 + 300 + 400 + 600 (1.1) (1.1) (1.1) (1.1) = 90.91+ 247.93 + 300.52 + 409.8 = 3 + 360/409.8 = 3.88 yrs for project L

ADVANTAGES OF THE DISCOUNTED PAYBACK METHOD

1. includes time value of money2. easy to understand3. does not accept negative estimated NPV investments4. biased toward liquidity

DISADVANTAGES1. may reject positive investment2. requires an arbitrary cutoff point3. ignores cash flows beyond the cutoff date4. biased against long term projects, such as research and

development and new projects

NET PRESENT VALUE An investment is worth undertaking if it creates value than it cost us to

acquirer its owners. In the most general sense, we create value by identifying an investment worth more in the market place.

NET PRESENT VALUE (NPV): is a method of ranking investment proposals which is equal to the present value of future net cash flows discounted at the marginal cost of capital.

DECISION RULE : accept an investment if its NPV is positive and reject if it is negative.

How to implement this approach 1. find the present value of each cash flow, including both inflows and

outflows, discounted at the project’s cost of capital 2. sum these discounted cash flows: this sum is defined as the projects NPV 3. if the NPV is positive, the project should be accepted, while negative NPV

should be rejected. If two projects are positive and mutually exclusive, the one with the higher NPV should be chosen.

What’s Project L’s NPV?

10 8060

0 1 2 310%

Project L:

-100.00

9.09

49.59

60.1118.79 = NPVL NPVS = $19.98.

eg

1. Suppose we are asked to decide whether a new consumer product should be launched. Based on projected sales and costs, we expect that the cash flows over the five year life of the project will be GHC2000 in the first two years, GHC4000 in the next two and GHC5000 in the last year. It will cost about GHC10,000 to begin production. Assuming the cost of capital is 10%. What should you do?

2. suppose we believe the cash revenue from students will be GHC20,000 per year, cash cost (including taxes) will be GHC14,000 per year. The business would be winded down in eight years. The plant, property and equipment will be worth GHC2000 as salvage at that time. The projects cost GHC30,000 to launch. The firm uses a 15% discount rate on new project such as this. Is this a good investment?

If there are 1000 shares of stock outstanding, what will be the effect on the price per share of taking this investment.

Accounting rate of returnThis is an investment average net income divided by its average

book value.AAR = Average net income/average book valueRule: a project is accepted if its average accounting return exceeds a

target average accounting return.

advantages disadvantages

Easy to calculate Not a true rate of return, time value of money is ignored

Needed information will usually be available

Uses an arbitrary benchmark cutoff rate

Based on accounting book values, not cash flows and market values.

Eg. Suppose we are deciding whether or not to open a store in a new shopping mall at Achimota. The required investment in improvements is 500,000 Gh. The store would have a life span of 5 years. The required investment would be depreciated on a straight line basis over the 5 year period. The tax rate is 25%. The following are the revenue and expenses for the project over the period. Calculate the ARR of the firm.

Year income expenses

1 433,333 200,000

2 450,000 150,000

3 266,667 100,000

4 200,000 100,000

5 233,000 100,000

Sol.If the firm has a target AAR less than 26% then t5his investment is

acceptable otherwise it is not.

item 1 2 3 4 5

Revenue 433,333 450,000 266,667 200,000 233,333

Less expenses

200,000 150,000 100,000 100,000 100,000

EB depreciation

233,333 300,000 166,667 100,000 133,000

Less depreciation

100,000 100,000 100,000 100,000 100,000

EBT 133,333 200,000 66,667 0 33,000

Tax (25%) 33,000 50,000 16,667 0 8,250

Net income

100,000 150,000 50,000 0 24,750

Average net income = 100,000+150,000+50,000+0+24,750/ 5 = 64,950

Average book value = 500,000 + 0 /2 = 250,000AAR= 64,950/250,000 = 0.2598 x 100 = 26%